Money Management for Financial Markets

If you are serious about trading on any kind of time frame you have to know what you are going to risk before you buy or sell short. This is true in any kind of business. With the stock market you can be extremely specific on your loss expectations because of the vast amount of liquidity in the markets. With a stock exchange that is open 24 hours a day 5 ½ days a week there is ample opportunity to know your risks.

In order to succeed in any kind of venture you have to treat it like a business. You wouldn’t start a successful retail business without planning the various aspects of what to market and who you are going to market towards. You must treat trading the same way. Far too many beginners haphazardly start trading thinking they will make quick fortunes. That is nothing more than a mental trap. The stock market is, as much if not more, a mental business than the technical and fundamental information it trades on. Opening an account without a game plan is a plan for disaster.

If you are brand new to trading you should go out and open a practice account. It is critical that you treat this account like it is real money. Don’t leave trades open that you would profit on with real money and don’t let losers run. You need to prove to yourself that you are a successful trader, and to do that you need to see the beginning balance grow, no exceptions or excuses. After you have successfully added value to your account over a 3 month time period is it acceptable to start trading live.

It is imperative that you always review and journalize your trades. You can learn a great deal from winning and losing trades. Always take the time to review outcomes and brainstorm possible new ideas. This could help you find better exit areas or improve moving stops to breakeven and so forth. There is always room to learn and improve your trading plan it just needs time and commitment.

There are many simple and complex money management strategies available to investors and traders alike. For this discussion I am going to keep it simple. This money management system should be used for your demo as well as your live trading account. There is no point in testing a trading system and money management strategy to completely change it when you go live. This may seem obvious but many people go big when they think they know which way the market is going. Even with a strategy that you prove to be successful, let’s say 90% of the time, you can blow an account with haphazard risk profile or lack of one.

A good approach is to start small. The problem with beginner traders is their accounts are generally small. This is generally less than $20,000. It is difficult to watch perfect trades from execution to closing only make you several hundred dollars. A good way to think about this is to duplicate the strategy with an account that is 10x your size. Would you hold on to this same trade if that several hundred dollars was now several thousand dollars or more? The whole process is about gradually building your account. Albert Einstein said compound growth is the 8th wonder of the world. This is what needs to be on your mind at all times.

So let’s get to this basic money management system. It is actually quite simple in theory. You need two variables before you enter your trade. Where will I enter the trade and where will I exit if the market proves me wrong. Being proven wrong can be hard to handle at first but it is a certainty in stocks, bonds, futures, and forex markets. You need to have the exact price you want to stop yourself out and where you will enter. This can be decided on by many factors but we will leave these fundamental things for a different discussion. Now you have your stop and entry price. Simply plug these numbers into a calculator and get a spread. EX. Enter SNDK short at 47.46 with a stop set at 50.77. 50.77-47.46= $3.31. This means there is $331 at risk for every 100 shares you purchase. You would need to take your account value and calculate 1-3% to determine how much money you should risk. 3% is towards the high side and should really be used for more experienced traders after you have proven yourself on a live account (probably a year but this is a personal judgment). So let’s assume you have $50,000 in your trading account. $50,000 *.02 = $1000.00. So you can risk one thousand dollars on this trade. Now you need to calculate how many shares to purchase so you only risk $1000.00 or less. Always round down. This would be 302.115 rounded down to 302 shares. This is calculated by (1000/3.31).

There are many more strategies that are based off this simple approach. We will go into more detail about how to manage the trade after you have entered a trade and how to strategically exit the trade. Come back in the following days and weeks for more information on stocks, bond, futures, and forex markets.